Title: Prospects for the UK economy
1Economics and Business ExchangeSupported by
Deloitte.
2Monetary Union in EuropeRay Barrell
3Outline and Plan
- Why do we have a Monetary Union in Europe
- The origins of the project and the idea
- The political and economic steps to union
- Why was EMU designed like this
- What is the role of the ECB
- Why do we have a Fiscal Pact
- Has EMU been a success
- What has happened to inflation
- Why has output growth been slow
- What will happen when new members join
- Does it matter that the UK is outside
4The monetary union project
- Plans and discussion for monetary union started
in the late 1960s and early 1970s - Early plans were disturbed by events in the early
1970s and were delayed - Inflation rates in Europe diverged
- The Exchange Rate Mechanism was set up in 1978 to
create a converging path to monetary union - The Maastricht Treaty in 1990 was designed to set
up the conditions
5The political economy of union
- EMU has been at least as much a political process
as an economic one - Germany was the most successful economy in post
war Europe - Austria and the Netherlands were in effective
monetary union with Germany from 1983 - Political pressures fro union came as strongly
from Netherlands and Belgium as France - There was a desire for a tight EMU
- Others saw EMU as a way of dealing with their own
political failings, and Italy and Spain saw it as
a tool to induce structural change
6Three Dimensions for Policy
- Ensure high levels of output and sustainable
trajectories for growth - Low and stable inflation
- High inflation may be related to unstable
inflation and is often unexpected - Contracts are hard to design in a world of
unexpected inflation variability - Limit the scale of cycles and crises
- Cycles have been becoming more damped
- The risk of financial crises has not fallen
7Enhancing growth and stability
- Output depends on factor inputs and the
efficiency with which they are used - Policy should increase supplies of factors
- Increased competition increases efficiency
- The national and international saving and
investment balance determine real interest rates - Lower real interest rates increase capital and
output - Lower risk premia increase the level of capital
per unit of output - Crafts and OMahony show core Europeans have 25
more capital per head than the UK
8Inflation and Risk
- Lower inflation and output volatility reduces
risk and affects decision making - Lower premia mean a lower cost of capital, more
investment and a higher capital stock - Higher capital means more output for a given
level of labour input - Exchange rate instability increases risk and
reduces investment and output - Monetary union membership for the UK may raise
inflation volatility and will reduce exchange
rate volatility
9Labour productivity in EU (person hour in ppp)
relative to the US
10Productivity and growth
- Output per person hour is higher in core Europe
than in the US or the UK - Over the last 30 years the core Europeans have
caught up with and overtaken the US - UK performance has improved marginally recently
11Participation, hours and activity
- Participation rates are lower in core Europe than
the US or the UK - Hours are shorter in core Europe
- Methods of constructing the national accounts
differ significantly - Core Europe has a lead in output
12The events of the 1970s
- The collapse of Bretton Woods was triggered by a
German refusal to accept the inflation rate
determined by US policy - Outcomes varied across Europe, but German policy
was much more successful - Germany kept inflation stable
- The UK and Italy performed badly
- It is not clear that floating exchange rates were
a success
13Inflation
14The ERM and the path to Union
- Exchange rates became more stable in the 1980s
with the ERM - Inflation began to converge but realignments were
common - Exchange rates became harder
- Fiscal policy had been loose in the 1980s
- The Maastricht Treaty put constraints on fiscal
policy - Deficits were limited
- Debts had a ceiling
- The ERM crisis of 1992 to 93 made the process
look unstable
15Choosing the members
- In the early 1990s plans involved a small
membership with tight constraints - Fiscal constraints were the most important
- Deficits had to be under 3 of GDP
- The debt criteria disappeared
- Exchange rate stability and interest rate
convergence was required - These were not always imposed
- Why was a deficit ceiling chosen, and what was
wrong with the Golden rule
16What is the constitution
- The monetary constitution gives the ECB the right
to choose its own inflation target - Is this a democratic deficit
- What are the role of rules
- The background to the ECB must be seen in German
Ordliberalism (not Mill and utility) where rules
constrain politicians - The three pillars of the constitution are price
stability, competition and the constrained state
with dispersed responsibility
17EMU and the single market
- The Common Market has always been more than a
free trade area, and it involved integration of
standards and rules - The single market has removed barriers to trade
and to capital mobility - It was designed to enhance competition
- Competition reduces rents and raises output
- The first phase increased trade
- The removal of the currency barrier was the last
step and appears to have increased cross border
capital mobility
18Fiscal Pacts in EuropeBackground
- Debt stocks rose to high levels by the early
1990s raising real interest rates - Debt stocks rose because fiscal policy was
expected to reduce unemployment - High unemployment was structural not cyclical and
fiscal policy did not work - Lower debt was needed to help reduce real
interest rates and raise equilibrium output - Labour market polices were needed to deal with
structural unemployment
19Why do we need Fiscal Pacts
- Governments need fiscal pacts with their people
to enhance growth - The assurance of no excessive borrowing reduces
expected real interest rates - Lower borrowing reduces the risk premium
- It lowers the risk of default
- it reduces the pressure for higher inflation to
be used to reduce the debt burden - The UK has a Fiscal Pact between the people and
the state based on the Golden rule - Does the golden rule have any basis in economic
theory or it is just a guideline
20Why does EMU need a Pact
- In Monetary Union the gains from fiscal expansion
are mainly in the home country - Spillovers are shared by all members
- Increased real interest rates are shared, and in
the long run reduce output everywhere - The costs of higher inflation are shared because
of the pressure of the risk of debt default are
shared everywhere - Default risks lie with the country and the
lenders not the Euro Area
21EMU and monetary target independence
- The ECB has the constitutional remit of
maintaining price stability - It started with a range of 0-2 per cent but was
clear that this was not centred at 1.0 - It now has a target of close to but below 2.0
- How can 2 per cent be price stability
- Why does price stability matter
- Longer term contracts are secure
- Second round effects from oil seem limited
- What are the achievements
22Monetary Policy
- Monetary policy is handled to the ECB
- It has goal and instrument independence
- It is not clear that it is fully effective
- Policy under the Bundesbank was clear
- Behaviour was constant over 25 years,
- Inflation and its volatility were the lowest in
the G7 - Real exchange rate volatility was low
- ECB behaviour is clearly different
- It appears to have less response to deviations of
inflation above and below target
23Euro Area Inflation Expectations
- Since oil price began to rise
- US inflation expectations up 0.7 pp on average
p.a. over next 10 years, and 1 pp over next 5
years - Euro Area expectations up just ¼ pp
- Exchange rate developments
- The decline in the dollar raise US inflation
expectations - Monetary policy regimes
- The US may be expected to be more accommodating
- Different cyclical positions
24Has EMU been a success?
- We need to judge EMU on growth, stability and
inflation - Has inflation been near target
- Has the exchange rate been stable
- Has growth been satisfactory
- We also need to ask what else has been going on,
and how this affected individual countries ands
the Union as a whole - Globalisation and trade agreements
- Technical change and new products
25Inflation performance
26Fiscal policy has the SGP worked
27Why and where has growth been weak
- Growth has been weak in Germany and Italy and
recently in the Netherlands - Performance in France has been OK and robust in
Spain and Finland - Overall growth has been weak but this may not be
because EMU has been set up
28Misalignments and the effects of entry
- Overvalued currencies on entry would have caused
slower growth - Germany and Italy were overvalued, Netherlands
and Spain undervalued - Growth differentials partly reflect adjustment
- Germany controlled policy until 1999, and it was
designed to reduce volatility there - EMU will have raised perceived volatility in
Germany but reduced it elsewhere - All these should net out leaving growth for EMU
unchanged -
29Technical progress and productivity growth
- Germany has had slow growth in labour
productivity - blamed on inflexible labour markets
- Other countries in EMU are similar
- The US has had a wave of technical progress
raising labour productivity - The US moved first with new products, and its
education system and labour market were more
suited to these developments
30Trade and globalisation
- World trade agreements have changed potential
output in EMU - Italy has been badly hit by the ATC because of
its production structure - Italy has had very major fiscal consolidation
over the last decade
31Products and processes
- The world economy has been going through a period
of product innovation after decades of process
innovation - EMU may have slow growth because of the design of
its institutions - Long term attachments between firms and workers
with extensive on the job training are different
from the US pattern - EMU styles may be better for process innovation
and it may be unwise to change - We may have seen waves of catching up and falling
behind because of these difference
32Will expansion make EMU more difficult to sustain
- Estonia, Lithuania and Slovenia may join this
year if inflation and budget deficits allow them
to do so - Why are they joining and will it change anything
in this case not much - Poland, Czech Republic and Hungary will join by
2010 Poland is half of NMS - For given inflation in core Europe they mat raise
the required inflation target by 0.06 initially
and 0.2 perhaps in 2010 - These expansions will be easier to manage than
the inclusion of Italy and Spain at the outset
33Does it matter that the UK is outside EMU
- The SMP and economic integration is not complete
without UK membership - The costs to EMU are likely to be small
- The costs to the UK may exist
- It is not clear that the UK will be more stable
and grow more outside EMU but costs of staying
outside will be low - Real exchange rate stability is less likely
outside and this is the major factor affecting
investment risk premia
34Conclusion what will happen to EMU
- Exchange rate regimes fall apart slightly more
often than countries do - The economic benefits are clear, but the
political will has to remain - It is not clear that Italy would find life any
more comfortable outside EMU, but devaluation and
inflation can help when you have structural
problems - EMU may be a better option than a repetition of
1933 to 1945
35Economics and Business ExchangeSupported by
Deloitte.